TSL: Greater Transparency Could Spark Near-Term Rally

Solar stocks have seen a sharp pullback since the start of 2008, and short-term rallies from current levels should be expected.

Upcoming catalysts for near-term rallies include the announcement of new supply deals, better than expected earnings results, short squeezes and the potential for supportive legislation. The more important question investors will need to ask: Are solar fundamentals deteriorating? Banc of America analyst Eric Brown recently suggested that solar will soon follow the trend of ethanol stocks, where attractive valuations can be trumped by deteriorating industry fundamentals. Several analysts have criticized the Banc of America note, arguing that solar stocks will continue to shine. It is refreshing to hear disagreement among analysts covering the solar sector, and this is most likely a reality check after the runaway gains seen among solar stocks in 2007. We will discuss the industry outlook first, and then focus on the specific case of Trina Solar (TSL – Last trade $32.62).

Solar industry bullish arguments:

  • Legislation is expected to remain supportive of solar growth.
  • Solar's market size is expected to grow, with major nations reaching grid parity by 2010.
  • Even though the mature solar markets (e.g. Spain and Germany) are expected to slow down, the slowdown can be counterbalanced by strong growth in additional markets in Europe, Asia and the United States.
  • Empirical studies by the likes of Cowan & Co. suggest that solar expansion projects are financed with lower internal rates of returns, often in the high-single digits. The argument here is that solar expansion projects are not as risky as other expansion projects, and these projects will continue to attract capital.
  • In the case of downstream companies, it can be argued that a higher supply of polysilicon will lead to lower prices, driving demand elasticity.

Solar industry bearish arguments

  • Some argue that decelerating demand in Spain and Germany, due to declining subsidies, will drag on solar industry growth.
  • Bears argue that the recent performance of solar companies have been inflated to levels that can't be sustained. They point out that both Germany and Spain have seen significant demand acceleration ahead of subsidies cut, and this source of growth can no longer be relied on.
  • Bears point out that the barriers to entry for upstream companies (i.e. PV cell and module manufacturers) have diminished. Bears argue that increased competition, i.e. the emergence of thin film technology and Chinese production, will lead to lower prices and lower margins.  
  • Bears believe cracks are appearing in solar fundamentals, pointing to Q4 earnings calls that have been disappointing for the Chinese solar manufacturers.

I tend to lean towards the bullish outlook for solar stocks, but the bullish case is not strong enough to justify the inflated solar valuations we saw towards the end of 2007. I believe that greater competition will have a limited impact on margins, as long as the solar market keeps growing faster than the rate of competition increases. Although it is worrying that solar growth in Spain and Germany may slow down. Investors could miss out if they ignore potential growth in other markets, especially the United States.

Although I am not completely sold on the idea, I think it's an interesting suggestion that the recent performance of solar companies have been inflated to unsustainable levels due to isolated growth spurts in Spain and Germany.

Speaking broadly, solar stocks would have to pull back some more before I consider buying. Going by this assessment, investors should use short-term rallies as opportunities to take some profits after stellar gains in 2007.

Is TSL a buying opportunity?

Investors seem to be worried by TSL's polysilicon exposure. Banc of America points out that about 20% of their FY08 needs are not locked in, and if they had to purchase polysilicon in the spot market it could erode gross margins. Banc of America also estimates that TSL will need to raise about $1 billion to finance its 10,000 MT polysilicon facility, due to come online between FY09-FY11. Given current conditions in credit markets, investors are worried that TSL will have to substantially dilute existing shareholders to raise these funds.

The main reason to be bullish about TSL is their vertical integration strategy, which should allow the company to capture more margin along the value chain. Because TSL is vertically integrated, at similar polysilicon cost, gross margin should be higher than for companies that only focus on cell production. Surprisingly, this is not the case.

TSL's P/E ratios trades near the low end of comparables, and I believe this valuation reflects a lack of transparency. The market is confused about the company's polysilicon expenses, and the lack of Q4 guidance did not ease investor nerves. TSL is expected to announce Q4 earnings before the open on March 4, and management could use the results announcement as an opportunity to provide greater transparency. Needless to say, if transparency is not improved, the stock price could remain heavy.

I also expect TSL management to use the earnings announcement as an opportunity to ease concerns about financing for its polysilicon facility. TSL is not expected to reach the full 10,000MT capacity until 2012. Any capital raised this year is expected to be debt, and this will not lead to dillution of shareholders. Also, the expansion project will progress in stages, and the company need not develop the plant to full capacity if long-term supply/demand conditions do not warrant raising more capital.

Disclosure: I do not own TSL and I don't own any solar stocks.
Photo:Steve Roe, Creative Commons, Flickr